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The U.S. is so awash in hydrocarbons that Hollywood is making movies about the boom, yet one energy investment that should benefit -- master limited partnerships -- hit the brakes in 2012.

MLPs have been perennial favorites of individual investors, thanks to their unique tax structure and high income. Indeed, until last year they had outperformed the Standard & Poor's 500 for a dozen years in a row. Last year, however, the Alerian MLP Index returned less than 5%, to the broad market's 16%.

So what happened, and can a strong case still be made for these securities? The short answer is yes, but finding your way in this market is getting trickier.

Nearly 100 energy companies are structured as MLPs, which allows them to avoid corporate taxation. They pay out the vast majority of their cash flow to partners (i.e., shareholders). This encourages high payouts -- today on the order of 5.5% -- and creates an advantageous, albeit complicated, tax structure for investors as well.

The most common MLPs are companies that transport and store oil and gas, which gives them reliable cash flow. These pipeline and storage companies typically charge a steady fee for their service, regardless of commodity prices. But the MLP landscape has changed dramatically in the past year.

For starters, there has been an explosion in U.S. drilling for crude oil and natural gas, which should funnel an estimated $250 billion into the U.S. energy infrastructure over the next 25 years. In October, the Internal Revenue Service expanded the types of energy assets that can qualify for MLP status.

And, let's face it, investors have been desperate for yield, making MLPs particularly appealing. All of this has been a red carpet for a huge number of new MLPs -- 30 brought to market in the past two years -- and a spate of new funds. The newest MLPs are a small percentage of the $400 billion industry, but some carry more risk.

A Year in the Life of MLPs

Hmm. Poor performance, an onslaught of new products, all amid a rapidly changing industry -- Barron's decided it was time to consult a couple of experts to see if the MLP heyday is over and how investors should proceed. Their answer? With caution -- though the U.S. energy boom should fuel many more years of solid MLP returns.

We also included Kyri Loupis, 42, a Cyprus native, in the conversation. Loupis spent nearly a decade in energy investment banking and MLP investing at Lehman Brothers before Goldman Sachs hired him in 2009 to launch its MLP investing strategy. He oversees more than $5 billion in MLP assets as head of energy and infrastructure investing at Goldman Sachs Asset Management.

Here's what they had to say.

Barron's:How is the MLP landscape changing?

Loupis: MLPs are a corporate structure with a different tax treatment. Those businesses can include different types of energy assets, each of which has different levels of volatility, risk, and cash-flow stability. Not all MLPs are created equal.

Eades: Over the past 10 years, MLP growth was driven by energy corporations, typically pipeline companies selling assets into MLPs, a strategy known as a drop-down. Today, the explosive growth in the production of crude oil, natural gas, and natural-gas liquids like ethane and propane has resulted in a massive build-out of new energy infrastructure, including new pipelines, processing plants, and storage facilities, which will drive the sector's growth. The second change in the MLP landscape is the recent creation of MLPs with atypical assets. These new, riskier MLP offerings have garnered a lot of attention, and some have done well, but they make up less than 5% of the sector's market value.

Loupis: Many are nontraditional assets. They're refiners, fertilizers, frac sand [a material used in hydraulic fracturing, or fracking, a process of extracting oil, natural gas, and natural-gas liquids from rock]. Most of these companies have a "variable distribution policy," not the traditional policy of stable, growing distributions. For example, U.S. refining is going through a major boom, and refining MLPs will certainly participate in the sector's up-cycle, but whatever distributions they pay in boom times may not be there when the refining cycle goes in the other direction.

Are MLPs with variable distributions riskier?

Eades: The distribution will go up and down with the underlying cash-flow streams.

Loupis: In the Alerian MLP Index of 50 names at the end of last year, the spread between the lowest and the highest yielder was 10.3 percentage points. That reflects the growth, risk, and volatility of the assets in these nontraditional MLPs. Some nontraditional MLPs that are not in the index have yields as high as 20%. But that's not sustainable.

Eades: We try to limit our exposure to commodity prices, so we didn't buy any of the new, nontraditional MLPs.

Eades: MLPs pass on 80% to 90% of cash flows to investors, and retain a little bit for internal purposes. Since they distribute virtually all their cash, growth, such as buying or building an asset, is typically financed by issuing new shares or debt.

How is an MLP's distribution taxed?

Loupis: Investors receive distributions that reflect their share of an MLP's cash flow. Their K-1 tax form reflects their share of the business' taxable profits. An MLP's assets—such as pipelines—produce cash and have a long life, but can be depreciated over a shorter period, reducing the amount of profit that is taxable. Taxable profits are typically about 20% of the cash distribution an MLP pays out annually. That's why sometimes you hear "MLP distributions are 80% tax-deferred."

The part of the distribution that isn't immediately taxed is considered a return of your capital, which reduces your cost basis. When you hold an MLP for a long time, your cost basis can whittle to zero. At that point, annual distributions are taxed as capital gains.

Eades: Which is still better than the tax rates on ordinary income.

What are the tax implications when selling?

Eades: You incur what is called recapture, similar to owning real estate. Let's say you owned an MLP for 10 years and went from a $20 cost basis to zero, because you received $20 worth of distributions that were not taxed. When you sell, you'll owe ordinary income tax on that $20.

MLPs are equities, but you use different methods to value them?

Eades: Price/earnings ratios are not relevant because an MLP's ability to depreciate its assets reduces its reported earnings. Ebitda [earnings before interest, taxes, depreciation, and amortization] is useful, but the enterprise-value-to-Ebitda multiple reflects unlevered cash flow, and MLPs finance much of their growth from issuing debt. We look at distributable cash flow, which is Ebitda minus interest expenses, capital spending, and after the general partner is paid.

Kyri Loupis, Goldman Sachs Asset Management

Loupis heads GSAM's energy and infrastructure investing, and manages more than $5 billion in MLPs. Some of his favorites:

Eades: The distribution coverage ratio -- which is the distributable cash flow an MLP generates divided by the cash flow it distributes to investors. Anything greater than 1.0 means the MLP has cash flow in excess of what it is paying investors. It shows how much cushion the MLP has.

That's all well and good, but most investors are interested in MLPs for their yield.

Eades: Yes, most MLP investors are maniacally focused on yield, yield, yield as the only valuation metric. But they should also consider the yield's growth. The total return of an MLP is the yield plus the growth rate of that yield over time. In the past three years, stocks in the Alerian MLP Index that grew distributions up to 3% annually generated an annualized total return of 8.5%. Those that grew distributions by more than 10% every year generated a 27.7% annualized return. Yield by itself? Not so interesting.

Gives us an example.

Eades:Oneok PartnersOKS 1.3902681231380338%ONEOK Partners L.P.U.S.: NYSEUSD40.84
0.561.3902681231380338%
/Date(1427835969537-0500)/
Volume (Delayed 15m)
:
1116740AFTER HOURSUSD40.84
%
Volume (Delayed 15m)
:
P/E Ratio
17.45299145299145Market Cap
10244422048.3356
Dividend Yield
7.737512242899118% Rev. per Employee
5382410More quote details and news »OKSinYour ValueYour ChangeShort position
[OKS]. It operates pipelines that gather, process, and transport natural-gas liquids. It could grow distributions 13% in 2013 and 2014. Its 4.7% yield is lower than the sector average, but this is one of the best organic-growth stories. It has $7 billion in projects that should help generate a 17% total return over 12 months.

How much distribution growth do you want to see, generally?

Loupis: Our bias is toward consistent and above-average distribution growth -- at least 8% growth. Safety of distributions, the coverage ratio, is important to us. Three MLPs cut distributions in 2012 -- and they weren't structured with variable distributions.

Where are the most appealing MLPs operating today?

Loupis: We stick to what happens in the exploration and production sector, where there is drilling activity, where there are oil-and-gas-production trends. Three things matter: product, function, and location. The area to be in over the next couple of years is logistics for crude oil and natural-gas liquids.

Chris Eades, ClearBridge Investments

Eades manages about $4 billion in three closed-end funds. He favors MLPs with stable payouts that are likely to grow significantly.

Company / Ticker

Recent Price

12 Mo. Chg

Yield

Industry

Comment

Oiltanking Partners / OILT

$43.33

34%

3.60%

Crude oil logistics

Gulf Coast storage expansion could result in two years of 16% total returns.

Western Gas / WES

57.04

27

3.6

Gathering/processing

More assets added by parent mean 16% distribution growth in 2013.

Targa Resources / NGLS

41.04

-1

6.6

Gathering/processing

More fee-based business should produce 17% total returns in next year.

Oneok Partners / OKS

60.59

-1

4.7

Pipelines, gathering/processing

Among best MLP growth stories, 13% distribution growth in 2013, 2014.

Sources: Thomson Reuters; ClearBridge Investments

What MLPs do you favor today, Chris?

Eades:Targa Resources Partners NGLS 0.16953257447323808%Targa Resources Partners L.P.U.S.: NYSEUSD41.36
0.070.16953257447323808%
/Date(1427835943012-0500)/
Volume (Delayed 15m)
:
870086AFTER HOURSUSD41.4644
0.1043999999999980.2524177949709865%
Volume (Delayed 15m)
:
P/E Ratio
14.824372759856631Market Cap
7330378881.4093
Dividend Yield
7.833655705996131% Rev. per Employee
6389780More quote details and news »NGLSinYour ValueYour ChangeShort position
[NGLS], which gathers and processes natural gas and natural-gas liquids, and sells to other energy companies and retail distributors. Half its revenue is from steady fees, while half is exposed to commodity prices. In 2014, as a laundry list of new projects come into service, they will be 65% fee-based, 35% commodity-exposed. The market is still treating this stock like it's the old Targa, with an enormous amount of commodity-price exposure. Given the organic-growth opportunities, you're looking at 11%-to-12% distribution growth in 2013 and 2014. Total return over the next year could be 17%.

What else?

Eades:Oiltanking Partners
[OILT] is my "geography matters" pick. Where assets are located is extremely important in determining an MLP's growth prospects. They own two primary assets, one in the Houston Ship Channel, and one in Beaumont, Texas, and they own storage assets. Nothing sexy, [but] they are completely fee-based assets. As we see more and more barrels moving from the Bakken, from the Rockies, from the Permian Basin, from Canada, to the Gulf Coast, this company is extremely well positioned to deliver growth in storage capacity along the Gulf Coast. The yield is lower than the average MLP company, but they have an above-average distribution-growth profile. They'll grow the distribution by 13% in 2013, and another 13% to 15% in 2015. Total return over the next year could be 16%.

Eades: All MLP strategies are not created equal, much like the stocks themselves are not created equal. I looked at various products and ways to get exposure to the asset class: open-end funds, closed-end funds, exchange-traded funds, exchange-traded notes, the Alerian index. What is amazing is that over the past two years, the range in total return is 5% to 37%. That is remarkable for an asset class that most investors think is rather homogenous. That can be due to the leverage used by many funds.

What role do MLPs play in a portfolio? Are they a commodity allocation? Or income?

Kyri Loupis is willing to buy nontraditional MLPs for a riskier portfolio, but says they're not long-term holds.
Gary Spector for Barron's

Loupis: MLPs are equities. There is this misconception that they are a hybrid. They are not. As people take on more risk, the MLP story is easy to understand: equity exposure with high income. In the move from fixed income to equities, MLPs are well positioned.

How do MLPs compare to REITs?

Loupis: MLPs trade at a 300-to-350-basis-point [three-to-3.5-percentage-point] higher yield. MLPs delivered three times the growth, but the ownership and tax complexities keep MLP yields higher than REITs. Some MLP income doesn't fit well in a retirement account; REITs do not have that. Mutual funds can include no more than 25% of their assets in MLPs, otherwise the fund becomes a taxable C-corporation. The S&P 500 includes REITs now, but there is not a single MLP.

MLPs have produced a nearly 400% total return over the past 10 years. Is it too late in the game?

Eades: I get this question all the time. The answer unequivocally: We're in early innings. The growth we are seeing in production of oil, natural-gas liquids, and natural gas is very early. If energy companies do nothing but maintain their current level of drilling activity, we have 20 years of production growth, probably longer than that. This is not a multiyear story, this is a multidecade story.

When should a new investor get in?

Loupis: MLPs are a long-term, strategic allocation. But in the past two or three years, if you timed it right, you could have done very well. The postelection selloff was an overreaction, and an opportunity: MLPs were up 12.6% in January.

ClearBridge's Eades says MLPs' mediocre returns last year were an aberration, and next year we'll see 15% growth.
Gary Spector for Barron's

What happened last year?

Eades: We had $35 billion in new equity hit the market, and that had to be digested. The second thing was the fiscal cliff: Investors were trying to lock in lower capital-gains tax rates, and there were investors selling MLPs on the mistaken notion that the dividend-tax increase would affect MLPs. MLPs don't pay dividends.

What is your outlook for 2013?

Loupis: MLPs had distribution growth in 2012 in excess of 7%, the highest since the financial crisis. That growth should be similar or higher over the next two years. Some of the nontraditional MLPs may deliver little or no growth this year, but they'll perform well because retail investors will chase them for yield. Total returns this year could be 15%.

Eades: MLPs underperformed in 2012, but their fundamentals were solid. Over the past 10 years, the annualized total return for MLPs has been 13.5%. We expect 13%-to-15% annualized total returns over the next three years.

Thank you so much.

The New Breed of MLPs

Like most other income-oriented asset classes, master limited partnerships have increasingly tempted investors into riskier areas with the lure of higher yields.

Not so with many newer offerings. As a wider range of businesses -- including refineries, producers, and chemical-processing outfits -- have adopted MLP structures, four of the 17 MLPs that have come to market in 2012 and 2013 have adopted a variable distribution model, meaning they make no promise regarding how much they will pay out from one quarter to the next. Most provide unusually high yields at the outset -- some as astounding as 20% -- but operate in industries like refining, which have high cyclical risks and elevated exposure to commodity prices, which could imperil distributions down the road.

When it came to market last July, refinery and gas-station operator
Northern Tier Energy NTI 0.47581284694686754%Northern Tier Energy LPU.S.: NYSEUSD25.34
0.120.47581284694686754%
/Date(1427835857791-0500)/
Volume (Delayed 15m)
:
262786
P/E Ratio
9.562264150943395Market Cap
2341222994.729
Dividend Yield
7.734806629834254% Rev. per Employee
1918510More quote details and news »NTIinYour ValueYour ChangeShort position
(ticker: NTI) offered no minimum-payout guarantee. What it did offer: a 19% yield. Much like dividend stocks, such lofty yields can prompt concerns about sustainability, and some investors are already approaching it as a bifurcated market. "We like MLPs a lot, but we prefer pipelines rather than those that are heavily dependent on energy prices," says Krishna Memani, chief fixed-income investment officer at Oppenheimer Funds, who has lately been urging bond investors into more equity-like income investments. "If an MLP is entirely resource-based, the variability is very substantial," he says.

J. Michael Bollinger of Morgan Stanley Private Wealth Management sticks exclusively with traditional MLPs, seeking stable income and distribution growth over time. He compares the recent trend of refinery and variable-pay MLPs with an influx of exploration and production MLPs such as
Linn EnergyLINE -2.1238938053097347%Linn Energy LLCU.S.: NasdaqUSD11.06
-0.24-2.1238938053097347%
/Date(1427835600260-0500)/
Volume (Delayed 15m)
:
1230125AFTER HOURSUSD11.06
%
Volume (Delayed 15m)
:
P/E Ratio
N/AMarket Cap
3791726306.0667
Dividend Yield
11.305605786618445% Rev. per Employee
2098400More quote details and news »LINEinYour ValueYour ChangeShort position
(LINE) nearly a decade ago. Unlike pipeline contracts, Bollinger says, E&P assets naturally decline in value over time, and it took the market a while to figure out how to price the two sectors, relative to one another. He sees a similar challenge now. "Investors have no idea what the discount or the spread should be between the yield on these [new offerings] and the yield on a traditional MLP," he maintains. "Maybe four years from now, there will have been 10 more and we'll know where to price them, but right now the risk is that the whole subsector could be repriced."

A KEY QUESTION IS whether investors will regard any distribution cut as a calamity, as they might with a traditional MLP, or just par for the course. Case studies so far are few but already include Northern Tier, which on Feb. 11 reduced its quarterly distribution to $1.27 from $1.48. Its unit price -- the MLP equivalent of share price -- fell by only 6% and has since recovered. It now trades at $28.91, more than double its $14 initial public offering price.

Contrast that with what happened to
Inergy
(NRGY), a more established MLP that stores and supplies natural gas and propane. After mild 2011 winter weather cut into fuel demand and cash flow, Inergy in January 2012 halved its distribution. Its unit price plunged to $14.07 from $18.42 in one day. It has never fully recovered, most recently trading at $19.92.

Another variable-pay MLP that has had a tough time, even without a dividend cut, is
PetroLogistics
(PDH), which operates a dehydrogenation plant. It came to market last May at $17, but fell to $10.22 in less than two months and hasn't made it back to its IPO price, trading recently at $15.13.

Greg Reid of Houston-based asset-management firm Salient Partners says that unlike midstream MLPs, most recent variable-pay MLP IPOs, particularly in the refinery space, tend to be dominated by institutional investors, and that the newer varieties best serve different purposes for investors. "We view them as three- to 12-month holdings, not 12 to 60 months, and sometimes you've got to move out of them before the cycle turns against you," Reid says. "They're not buy-and-hold stocks."